EARNINGS for many US manufacturing companies have surprised on the upside despite flat to negative revenue growth.
In addition to cost cutting measures, many have benefited from a decline in input costs due in part to a fall in the prices of commodities.
The producer price index for commodities has risen more than the consumer price index from the beginning of 2007 till middle of 2008 (see chart), thereby putting pressure on margins as raw material costs rose more than selling prices. The squeeze in margins was compensated by rising sales volumes.
However, following the global financial crisis, producer prices for commodities plunged by 18% from July 2008 to a bottom in March 2009 compared with only a 3% decline in inflation.
This has helped boost the margins of manufacturing companies at a time when sales volume was dropping.
Nonetheless, with the rise in commodity prices, margins and profits of manufacturing companies may again be squeezed.
The massive injection of liquidity has stabilised banking sentiments. Other than China, where a government-directed bank lending spree of 7.4 trillion renminbi in the first half year has boosted real demand and the economy, real demand in major economies in the United States, European Union and Japan remains lacklustre.
In fact, the latest July retail sales in the US were down from a month ago. This is not surprising as US consumers have to deleverage from very high debt levels.
Following the bursting of the real estate bubble in Japan in 1990, the Japanese private sector had to deleverage, a process that has continued for 18 years.
The higher the leverage, the longer the period of deleveraging.
Hence, with the total debt to gross domestic product of the US at a record high ratio of 375% in the first quarter, the US deleveraging process is likely to last a long time, pointing to an L-shape stagnation.
Why the optimism in the financial and commodity markets? The central banks have flooded the global financial system with liquidity by lowering interest rates, providing cheap financing to banks and other ailing industries, and by printing money.
Since the demand for money is weak in the real economy due to weak consumer spending and capital investment, the liquidity has found its way into the financial markets.
Stock prices and commodity prices have rallied. Even property prices have stabilised and appreciated in some countries.
Ironically, a weak real economy means that policymakers are likely to tolerate a very lax monetary policy and low interest rates.
This is positive for the financial markets as the liquidity will find its way into the financial markets, and dare we say, speculation.
The hope of some policymakers is that the appreciation in assets like stocks, bonds, commodities and properties will be translated into growth in real demand.
This is potentially a dangerous game to play as a new bubble may be engineered to counter the previous one that burst.
Policymakers in the US inadvertently created a mega-housing and debt bubble in the US after interest rates were lowered in 2001 to counter the negative effects of the bursting of the Nasdaq bubble and 9-11.
Irresponsible lending was encouraged with the 2004 removal of the 15 times gearing ratio limit imposed on US investment banks.
Perhaps the economy should be allowed to cool down to a sustainable level so that the excesses of the previous bubble can be removed.
So far, none of the policymakers in the developed nations is willing to take the bitter medicine. It is easier to pander to the demands of the politicians and the people who want a quick fix.
Maybe the US and the world need to reappoint Paul Volcker the new Fed chairman when Bernanke’s term expires.
Volcker was willing to plunge the US economy into recession in the late 1970s in his successful fight to tame a runaway inflation in the US and the developed world.
Painful as it was, the taming of inflation set the stage for over 20 years of unprecedented global growth before the recent excesses plunged the world into a severe global recession.
If we are to stop these cycles from repeating, curbs have to be placed on consumer and government debt levels and on asset prices.
So far the lessons have not been learnt. Total debt levels are climbing as government debt arising from fiscal stimulus and bailouts is increasing faster than private sector deleveraging.
Mounting government debt and involvement in the economy could crowd out the private sector and lead to a long-term decline in productivity.
Higher debt levels in many developed nations could represent a burden on the next generation, who will be fewer due to an ageing population.
Without structural reforms, global growth, especially in developed world, rates are likely to be lacklustre. In the meantime, excess liquidity is likely to fuel the financial markets until reality sets in.
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